Many years ago I was discussing the economics of start-ups with an acquaintance, who told me that in his new start-up they were planning to avoid social security and medicare taxes by paying themselves $1 per year (saving 15% in taxes). They would then take the rest of their income as profit from the business.

I’d heard other people talk about the same strategy, but none so aggressive as these guys. I mean, $1? Talk about a red flag for the IRS. But those guys (I never did hear if they pulled it off) had nothing on Mr. Sean McClary:

Earlier this month, the U.S. Tax Court … ruled that a Subchapter S firm whose sole owner was Mr. McAlary, a California real-estate broker, should have paid him $83,200 in wages for 2006. Instead, he was paid zero.

The court ruled that the firm owed nearly $13,700 in payroll and unemployment taxes, plus more than $4,300 in penalties, for that year. Although the case can’t be cited as precedent, experts take such cases seriously.

$0 per year? That’s the equivalent of donning a Star Trek security guard uniform and beaming down to Planet IRS.

Mr. McClary claims that he wasn’t really that stupid:

When challenged by the IRS, he said he meant to claim at least $24,000, but that his tax preparer had made an error.

I’ll bet that if he had originally gone in at $24K (which is still ridiculously low), the IRS would have let it slide. But now that he set up a situation where they pretty much had to do something, it’s set a precedent that will reverberate throughout the Subchapter S community (some 4 million businesses).

As with anything, there will be positive and negative consequences. The government will get a higher share of Subchapter S income, but the economics of some small businesses may change to the point where their viability is threatened. Many small businesses will decide that the 15% pay cut will tip the scales against entrepreneurship, which already comes with a huge downside.

In the end I suspect that the economic damage will exceed the additional revenues to the government. But for now, Subchapter S owners be warned: pay yourself a market wage.